Target-dated funds are welcome but no panacea for pension holes
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Much is riding on target-dated funds. As this week’s FT series on pensions should make clear, defined benefit pensions face serious deficits — but the same mathematics of disappointing returns and ever greater expense for buying an income also applies to defined contribution plans.
DC plans have been poorly designed. For years, 401(k) sponsors were lulled by the equity bull market into allowing members to choose their own asset allocations, and switch between funds and asset classes at will. This was a recipe for disaster, as members tended to sell at the bottom and buy at the top. The strong returns of the 1990s convinced many that they could get away with saving far less than they needed.
The industry and regulators have been alive to the problem, and their response is sensible. Now they offer a default option of a fund that aims to ensure a decent payout by a “target date” — the intended retirement date. These funds automatically adjust their asset allocation between stocks and bonds as the retirement date approaches, which in general means starting with mostly stocks and shifting to bonds as retirement approaches. This (good) idea mimics the best features of a DB plan.
Such funds are undeniably an improvement on the “supermarket” model of the 1990s. Savers avoid the pitfalls of taking too much or too little risk, and regular rebalancing helps them sell at the top and buy at the bottom.
But TDFs have problems, which are growing increasingly apparent. First, are their costs under control? Second, do they have their asset allocation right? And third, can we benchmark their performance?
On costs, the news is good. US regulations require 401(k) sponsors to look at costs, and the response has been to drive down fees. According to Morningstar’s Jeff Holt, TDFs’ average asset-weighted expense ratio stood at 1.03 per cent in 2009, and by last year had dropped to 0.73 per cent — a 30 basis point fall, which in a low return environment could make a very big difference when compounded.
But if TDFs are coming under pressure to limit costs, the pressure over asset allocation is taking them in every direction. They are designed as mutual funds, so they still do not hold the kind of illiquid assets that the best DB funds can fund, such as infrastructure. That is a problem.
So is the entire balance between stocks and bonds. The notion from the DB world was to reach 100 per cent bonds by the retirement date, when the fund could be used to buy an annuity. With low bond yields making annuities expensive, and life expectancy far longer than it used to be, this no longer makes much sense. A 65-year-old, with a decent chance of making it to 90, should not be 100 per cent invested in bonds.
But high equity allocations tend to emphasise that the TDFs expose savers to greater risk than a DB plan. According to Morningstar the average drawdown for 2010 TDFs during the crisis year of 2008 was 36 per cent — a potentially disastrous loss of capital for people about to retire. As stocks rapidly recovered, and as those retiring in 2010 would have been unwise to sell all their stocks, this should not be a problem — but it plainly hit confidence.
The early stages are also a problem. Our 20s and 30s are a time of great expense. Should young investors really be defaulted into heavy equity holdings when the risks that they lose their job are still high, and when they face possible big drains on their income, such as a baby, or downpayments on a first house?
So the “glide path” of shifting from equity to bonds is controversial. And there is no standard practice on it. According to Mr Holt, TDFs’ holdings of bonds at the target date for retirement vary from 10 to 70 per cent.
What about benchmarking? Such differences make it impossible. Asset allocation differences swamp other factors, and are driven by different assumptions about risk.
Establish bands for asset allocation at each age, but allow them to vary according to valuation. Funds designed for retirement should never take the risk of being out of the market altogether. But if, as now, bonds and US equities look overpriced while emerging market equities look cheap, an approach that took US equities’ weighting to the bottom of its band, while putting the maximum permissible into emerging markets, would probably work out well.
There is not, as yet, an incentive to do that, and there needs to be. TDFs, or something like them, should be at the heart of future pension provision. It is good that their costs are under control, but there are ways to make them far more effective: by allowing more asset classes, accepting that people at retirement should still have substantial holdings in equities, and encouraging TDFs to allocate more to asset classes that are cheap.
More from the FT pensions series:
Podcast: The dark future A dramatic decline in bond yields has added to the pressures of longer lifespans and falling birth rates to create a looming social and political pensions crisis. John Authers and Robin Wigglesworth discuss the looming crisis
Pensions: Low yields, high stress In the first article of a series, the Financial Times examines a creeping social and political crisis
Canada quietly treads radical path on pensions Retirement funds push beyond bonds and stocks in search of better returns
Pensions and bonds: the problem explained Bond mathematics and the scale of pension deficits
Pension funds and alternative investments
Pensions demographics — all you need to know
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